Wednesday, October 05, 2011

Mainstream Multipliers

1.0 Introduction

"Theorizing aside, Keynesian policy conclusions, such as the wisdom of additional stimulus geared to money transfers, should come down to empirical evidence. And there is zero evidence that deficit-financed transfers raise GDP and employment—not to mention evidence for a multiplier of two." -- RobertBarro, Wall Street Journal

I find the above disingenuous, although cleverly worded to narrowly focus on transfer payments. Empirical evidence exists on Keynesian multipliers, thereby supporting the theory from which the policy recommendations are drawn.

In this post, I draw attention to four studies using Instrumental Variables (IVs) to estimate Keynesian multipliers. Currently, many economists find quite promising the use of IVs to emulate controlled experiments. For some more on the stimulus, that is, the 2009 American Recovery and Reinvestment Act, see Dylan Matthews' summaries of nine studies. I also have yet to make anything of Auerbach and Gorodnichenko (2011).

2.0 Methodology
The change in the ratio of public debt to GDP is increased by a rise in nominal interest rates, a fall in the rate of growth of real GDP, and a fall in the rate of inflation. The question addressed by this post is how to distinguish the effects of government policy on GDP from the effects of changes in GDP on government policy.

Some tax and government spending is endogenous to the economy. For example, a reduction in Gross Domestic Product (GDP) can result in:

Lower taxes, since the income on which taxes are based has declined, and more government spending on predefined social programs

Deliberate attempts at short-run government counter-cyclical increases in government spending and lower taxes.

One cannot easily use such endogenous changes to spending or taxes to identify subsequent causal effects from government spending and taxes on the overall level of economic activity. Accordingly, Christina D. Romer and David H. Romer (2010) consider exogenous changes to taxes, which generally fall into two categories:

Taxes to supposedly lower or raise long run rate of growth of GDP

Taxes to bring thedeficit closer to balance.

Romer and Romer consider quarterly USA data from 1945 to 2007. They look at narrative data, such as official reports, to classify changes in tax rates as endogenous or exogenous. The exogenous changes provide their IV which they can then use to identify subsequent causal changes in GDP.

David Cloyne (2011) applies this narrative approach for constructing a time series of exogenous tax changes to the United Kingdom. Jaime Guajardo, Daniel Leigh, and Andrea Pescatori (2011) extend this narrative approach across countries in the Organisation for Economic Co-Operation and Development (OECD).

Daniel Shoag adopts a different approach, applicable at the state level in the United States. He considers changes in state-level spending associated with windfall gains and losses in state pensions. A state pension is typically not invested in that individual state, and the dispersion of pension performance across states is exogenous, he argues, to the variation in the economic performance across states. So pension performance gives Shoag his IV. (His references include additional multiplier estimates, if I understand correctly.)

3.0 Results

Romer and Romer find lowering taxes by 1% of GDP raises GDP by 3% in 2 1/2 years.

Cloyne finds that lowering taxes by 1% of GDP raised GDP by 2.5% in three years.

2 comments:

I don't understand how you may base any "empirical study" on the "GDP" concept.

Indeed, as Keynes put it in the General Theory,

"[...] the community’s output of goods and services is a non-homogeneous complex which cannot be measured, strictly speaking, except in certain special cases, as for example when all the items of one output are included in the same proportions in another output."

The "GDP" doesn't deal at all with the "amount" of the production. It only measures the amount of money spent on consumers goods.

Moreover, because the "GDP" measures the amount of money spent on final goods, it is indeed quite easy for a governement to increase it: it is just needed, either to print new money, or to shift the current money from investment to consumption. But this increase "GDP" is obvioulsy not laudable.